All Commentary
Tuesday, January 22, 2013

Fracking, Controversy, and Water Markets


When a Hollywood star like Matt Damon makes a movie aimed at exposing the alleged dangers of otherwise technical and esoteric business activities, you know you’ve got a controversy on your hands. (FrackNation, though less star-studded, may also be coming to a theater near you.)
The controversy, of course, is about hydraulic fracturing, or “fracking.” In my home state of Colorado, you’d have to be living under a rock to know nothing about fracking. But if you happen to be living under a rock next to a chamber of trapped natural gas, then watch out: You're about to find out what fracking is, first hand. 
Fracking is a process by which water and other chemicals are used to fracture underground rock so that workers can access fossil fuels like natural gas and petroleum. Anti-mining environmentalists share a number of concerns about fracking, ranging from worries about groundwater pollution and degradation of surface vegetation to claims that fracking can turn neighbors’ kitchen faucets into blowtorches. 
Add the fact that Colorado is in a severe drought, and you get a compounded concern—mostly from an uninformed public—that oil and gas companies are going to buy up all the municipal water. That’s the concern we’ll focus on here, as there have been plenty of other pieces devoted to debunking environmental hysteria. Still, with conservation and “sustainability” in vogue these days, running out of water is on everyone's minds. This is especially the case in the arid West, where economic growth has been putting increasing stress on water supplies for decades.
It’s true that some of the water used for fracking is being sourced from municipal utilities. But most H2O is purchased from the wholesale market, where—unlike with public utility sources— prices reflect supply and demand. Who are the major players in this market? Public water utilities, of course, but mainly farmers, who rely on irrigation out here. 
This means that drillers will be competing for water primarily with agricultural users. Water rights—which means access to a given flow volume of water drawn from a specific location on a stream (and which are subordinate to “senior” claims if water levels are low)—are typically sold at auction. Oil drillers are bidding for water against other drillers and against farmers. They will only be willing to pay more if they value the water more highly than the farmers do, which has recently been the case due to the fracking-based oil boom. 
Case in point: Earlier this year the Aurora Sentinel reported that the city will sell $9.5 million worth of water to an energy company. Why? Because the company is offering four times the price offered by other customary buyers. Potential profits in oil and gas make the water highly valued by drillers. Of course, this valuation is subject to change along with the prices of oil, crops, and all of the other resources required to produce them. If oil prices decline relative to crop prices, drillers will bid less for the water and farmers more, and water will flow to its most highly valued use. In other words, when markets are allowed to work, it’s a beautiful thing.  
Public utility customers aren’t used to, and don’t really understand, how a free market works when it comes to water. Because a local water utility is seen by most economists as a natural monopoly, retail costs are fixed at low levels despite potential fluctuations in supply and demand. These low costs are accomplished not only through price fixing, but also through rationing (the public utility regulates when and how much water can be used, rather than consumers responding to true prices). 
Water rationing usually affects what the utility considers a low-value use of the good, such as lawn watering. You are permitted to water your lawn only during certain hours, on certain days, and for a certain amount of time. Even if you have a prize-winning English garden in the middle of a desert and would gladly pay more for water, you aren't given that opportunity. The guy next door with the dandelion lawn, whose sprinkler spends more time spraying the sidewalk than the grass, has no incentive to be more careful with his water, except when he’s forced to follow the directive of the local authority and water his sidewalk on Tuesdays and Thursdays between the hours of 6 and 8 p.m.
Because there is no price incentive for the average public utility water customer to respond to, there are very few creative conservationists. Instead, public utilities resort to ridiculous advertising campaigns aimed at persuading their customers to use less of their products. You’ve probably received the flyers or seen TV ads sponsored by your water and electric utilities offering tips on how to use less. A more direct way to economize on water and energy use might be to let prices fluctuate for public utility customers like they do for customers in the wholesale market. 
Imagine if other businesses operated on the public utility model of rationing and/or persuasion campaigns. You might receive a flyer from a Shell or a Conoco suggesting several ways you could economize and use less gas, and offering you a rebate if you cleaned your fuel injectors or switched to a standard transmission. The last line of the flyer might read, “Working together, we can use less gasoline and help preserve this precious resource for the future.” (Not to give the government any ideas.) In any case, because oil refiners are not heavily protected monopolies, they’d soon go out of business.
But industrial and agricultural water consumers don't have to bother with this. In these sectors, wholesale water markets are alive and well. And what’s going on in these markets? As noted above, in Colorado oil and gas companies are making big buys in the wholesale water markets, and the use of water for fracking is expanding. But currently, the water used in fracking amounts to just 0.1 percent of annual water use in Colorado. Agriculture and irrigation, including for golf courses, use 85.5 percent. When it comes to annual precipitation, Colorado ranks 45th among the states, with 15 inches. Most Heartland states that we think of as agriculture's top performers average more than twice that. So maybe irrigated farmland isn't the best use of Colorado water or land. How much room is there for diversion of Colorado wholesale water supplies out of agriculture and into fracking and energy production? Nobody knows for sure, but with a free market in water, we're sure to find out what the highest-valued uses are. The price mechanism will tell us.
Here’s a final point that the anti-fracking folks should consider: The demand for water for fracking is a boon to farmers and even to municipalities who have stocked up on water rights. According to The New York Times, in Colorado, “Despite the drought and worries about water supplies, several cities—and even farmers with water to spare—are starting to line up as eager sellers.” So if farmers have water to spare, they can easily sell it to drillers at a profit. 
Like farmers who realize that collecting royalty payments from their mineral leases is more profitable than growing crops, perhaps some will learn the same about water rights for fracking. Still, the same farmers getting rich on oil wells complain that it is the end of agriculture. You can't have it both ways. I say, why not double-dip? Lease mineral rights and water rights to the same energy company and start cashing the checks. Iowa can grow the corn.

  • Joel Watts is a freelance writer and insurance adjuster in Colorado Springs, Colorado.